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The Case Against Small Caps

Busting the small-cap risk myth once and for all.

Ever hear the one about the guy from Santa Clara who bet the ranch on Intel (NASDAQ:INTC) in the mid-'80s, sold the stock 10 years later, and retired? It's the oldest story ever told. You may have heard a similar story about Microsoft (NASDAQ:MSFT), and the guy was from Yakima.

Either way, it's a fun story. But that sword cuts both ways, right? What about the less-fortunate chumps who get wiped out when their hot stock tip suddenly goes belly-up? Isn't that the problem with small caps, after all? That they're a crapshoot?

Well, you're smart to think that wayGo to Harvard Business School, and they'll tell you the same thing. Just be sure to pack a few hundred grand in small bills. Or save yourself some money and consider something else: What if the problem isn't with small-cap stocks, but with small-cap investors?

What if the problem with small caps is that they attract the wrong crowd? Maybe it's all those gamblers and daredevils, vying for the next home run, who create an illusion of a wacky and treacherous market.

Don't take my word for it -- reams of data support that very contention. But there's something more important than data -- how you can use this so-called illusion to make money.

Why small-cap investors get creamedAny finance professor can tell you why small caps are risky. Markets are illiquid, for one thing. Earnings are lumpy and less dependable. Capital is costly and hard to secure, especially when times get tough.

All true, but I'm not convinced that's why small-cap investors get worked. It's more insidious than that. It's because they don't invest. They speculate on stock tips and high-risk story stocks with low-quality earnings -- or worse, none at all. It's that simple.

Small-cap investors -- too many of them, at least-- ignore fundamentals. If you don't believe me, ask yourself this: When was the last time you heard some guy pumping a small-company stock at a party or on TV, and he wasn't focused entirely on the story?

Then again, who wants a cigar butt?Now, compare that with the stodgy old-timers who focus on mature large-cap, cigar-butt-and-smokestack companies trading at bargain-basement prices. Could these guys be more boring? They never talk story. They're all assets, cash flows, and valuation.

That's why they don't earn their full potential, either. They're too busy picking over Wall Street's scrap heap. After all, you could have made money on a fallen angel like Merck (NYSE:MRK) last year -- I did myself -- or by taking a chance on Ford (NYSE:F) right now, but their triples and quadruples are behind them. They're just too big.

But what if we could apply the old-school valuation techniques made famous by Ben Graham and Warren Buffett to up-and-coming smaller companies, while their growth spurts are still ahead? Again, it sounds simple, but you'd be amazed at how few investors even give it a shot.

Forget the next home run stockIf you're a regular here, you know about my run-ins with Motley Fool co-founder Tom Gardner. Along with folks like Chuck Royce and David Nierenberg (who we had the pleasure of meeting here at Fool HQ), Tom and his team at Motley Fool Hidden Gems are among the folks I've seen cashing in on this little trick.

The trick, of course, is shunning the next big thing and buying small companies with strong fundamentals at good prices -- in other words, small-cap value. The guys I just mentioned make money in small caps by balancing story and potential with fundamentals.

That's what led folks to Wal-Mart in the '70s. They turned $5,000 investments into $2.5 million. But what was so great about Sam Walton's general store back in 1975? Take a look at how Wal-Mart compared with some of today's whisper-stock party tips:

Company

Revenue

NetIncome

Five-YearSales CAGR

Five-YearEarnings CAGR

Wal-Mart (1975)

$236

$64

52%

33%

Hoku Scientific (NASDAQ:HOKU)

$5

($3)

360%**

N/A

Local.com (NASDAQ:LOCM)

$16

($13)

15%**

N/A

Transmeta (NASDAQ:TMTA)

$31

($41)

8%

N/A

*Revenue and income data are TTM and in millions. Data courtesy of Capital IQ, a division of Standard & Poor's. Wal-Mart data courtesy of company filings.**Trailing three-year data.

Clearly, while Wal-Mart delivered rapidly expanding revenues and profits back in 1975, that's not the case at the other companies in the table. In fact, these guys have no earnings to speak of.

That's not to say they don't have potential -- just that they're all potential. Speculating on them may work out for you, but it may not. The safer bet is to dig up companies like Wal-Mart -- when they're still small -- that can make you a lot of money methodically over the years.

After all, this trick turned $1,000 into $33 million Granted, it took nearly 70 years to do it, but still ... according to Ibbotson Associates, if you'd invested $1,000 in small-cap value stocks back in 1927, you'd have more than $33 million by now.

That's three times as much as you'd have if you'd invested in a broad basket of small caps, and more than 15 times better than if you'd bought large caps instead. Will those numbers hold up? Well, Tom Gardner has been mining small-cap value at Hidden Gems for nearly four years now, so judge for yourself.

So far, Tom has alerted his subscribers to more than 60 small-cap value stocks. More than a dozen subsequently doubled or more, and as of this morning, the entire portfolio is up 64.9% on average. That's compared with a respectable 27.5% if you'd bought the S&P 500 instead.

How about some really good news? You don't have to pay Harvard to find these great small-cap values. You can get Ben Graham's Security Analysis at the library. If you're up for flipping through 700 pages, that is. But there may be an even easier way -- and there's no speculation required.

Join Tom Gardner and Bill Mann at Hidden Gems free for 30 days. Check out the complete Hidden Gems service for a full month, including access to all of Tom's recommendations and all back issues. Then take a whole month to decide whether you want to join.

I guarantee you'll meet lots of friendly and knowledgeable folks, and there's no pressure to subscribe. Best of all, the first lesson is always on Tom. To take advantage of this special free trial, click here.

This article was originally published on Feb. 17, 2006. It has been updated.

Fool writer Paul Elliott owns Merck and promises to keep you posted on Tom Gardner's progress at Hidden Gems (yes, through good times and bad). You can view all Hidden Gems picks on his scorecard with your free trial. Intel, Wal-Mart, and Microsoft are Inside Value picks. The Motley Fool has a disclosure policy.